Has “Operation Twist” Backfired?

Highlights

  • Investors’ reaction to the Fed’s announcement of “Operation Twist” in which it will sell short-dated treasuries to buy longer-dated instruments has been surprising, as equities and other risks assets have plummeted on the news.  This contrasts with the favorable market response to the first and second rounds of quantitative easing (QE).
  • While the media has attributed the adverse reaction to the Fed’s statement about “significant downside risks to the economic outlook,” the more likely explanation is that investors are now realizing the Fed may be “out of bullets” in terms of being able to boost the economy.
  • With the Fed now targeting long term bond yields for the foreseeable future, the likelihood is that treasury yields will stay low for the next couple of years.

“Operation Twist” and Quantitative Easing

This past week the Federal Reserve unveiled its latest program to bolster the economy, which has been dubbed “Operation Twist.”  Specifically, the program entails the Fed purchasing $400 billion of intermediate to long-dated treasuries over nine months, which are to be funded through sales of a like amount of short-dated instruments.  The objective is to support the economy by driving down long-term yields, which are considered to be critical for the housing market and business capital spending.

Upon hearing the announcement, my assessment was that it contained no surprises, as most of the information had been anticipated by Wall Street economists. Therefore, I was surprised when over the span of two days the yield on the long-bond plummeted by more than 40 basis points, while U.S. equity markets sold off more than 7% and global markets sold off in tandem.

This reaction is completely opposite to that one year ago, when the Fed launched a second round of quantitative easing in circumstances that were very similar to those today.  Indeed, the stock market surged by nearly 30% though April of this year, along with other risk assets.

That begs the following question: Why did the markets react so favorably to QE2 and so negatively to “Operation Twist?”

One explanation is that investors believe that when the Fed expands its balance sheet through quantitative easing, it is equivalent to the Fed printing money. The problem with this interpretation, however, is that quantitative easing only increases the money supply if banks use the proceeds from new deposits to make loans. In the current environment, however, banks have been content to hold excess reserves, such that the money supply has not been augmented. Consequently, while QE2 made risk assets appear more attractive to investors, it had only a limited impact on the economy.

Significance of the Fed’s Statement 

Another explanation that has been put forth in the media is that investors mainly reacted to the Fed’s statement about downside risks to the economy. I find this unconvincing, because it takes the statement out of context. Following is the full commentary:

The Committee continues to expect some pickup in the pace of recovery over coming quarters but anticipates that the unemployment rate will decline only gradually toward levels that the committee judges to be consistent with its dual mandate. Moreover, there are significant downside risks to the economic outlook, including strains in global financial markets.”

When read in this context, it is clear the Fed’s base case is that the economy will grow slowly in the next few quarters, but it also acknowledges the greater risks are to the downside.  In light of everything that has been happened in recent months both here and in Europe, what else could the Fed have said!  This is hardly news to any investor who has been following developments in the U.S. and Europe.

In my opinion, the more likely explanation is that investors realized global economic conditions have been deteriorating all along, but they were holding out hope for a “Hail Mary” such as occurred one year ago. When the markets realized “Operation Twist” would, at best, have only a marginal impact on the economy, they threw in the towel and shed risky assets.

While investors increasingly may view the economy as being in a “liquidity trap”, I do not believe Chairman Bernanke is about to surrender. Indeed, as global conditions deteriorate there is greater likelihood the Fed will launch a third round of quantitative easing at some point. But I also believe the Fed will wait until there is clearer evidence that inflation is receding to do so. Only then will we know for sure whether the Fed truly is “out of bullets.”

Conclusion: Treasury Yields to Stay Low for the Foreseeable Future

Amid these developments, there is one clear message for bond investors.  Namely, with the Fed now committed to keep long-dated treasury yields low, the risk of a major back-up in yields has diminished, at least until there is signs the economy is improving.

This does not preclude the possibility that yields on corporate bonds could rise, but if they do, it would signify that investors are becoming more concerned about potential credit risks.  This already is evident in certain areas of the corporate bond market – especially financials and some BBB industrials – where spreads to treasuries have widened significantly. Consequently, we are exploring potential opportunities in the investment grade area, while also weighing risks that the economy could slip into a mild recession.